An economist’s advice to the industry: Hammer out the rules and bump up the R&D

Kathleen Davis, Associate Editor

In this spot, we have dissected the industry from every interior point of view from regulator to company executive. This month, we move a bit outside of our typical box to discuss the power industry with economic policy consultant Dr. Susan Tierney.

Dr. Tierney serves on the board of the Electric Power Research Institute’s (EPRI) Electricity Innovation Institute (E2I). She is a former assistant secretary for policy with the Department of Energy, and she served as secretary of environmental affairs and utility regulator for the Commonwealth of Massachusetts. She has seen the power industry from the inside, but she currently resides at Lexecon, an economic and policy and consulting firm, where she specializes in electric and gas industry issues.

EL&P spoke to her about her general views of the industry, her opinions on future growth, and her ultimate “fantasy roundtable” of power industry big-wigs.

EL&P: You’ve stated that America has a “hidden” energy crisis. Would you expand on that statement for our readers?

Tierney: There is an aging infrastructure problem, and it’s more on the transmission side of the fence than on the generation side—although, certainly, there are some large amounts of generating capacity that are Eisenhower-era. But, the transmission grid has just not kept apace, technologically, with the updates and enhancements that we are seeing on the generating fleet, and—potentially more importantly—the T&D side is not keeping up with the changing electrification of the country and economy. By that I mean the increasing extent to which the economy relies on electricity for everything—banking, telecom, security systems, etc.

One, the grid is not being added to, in terms of investment keeping pace with growing electric demand. Two, the “intelligence” of the grid—by that I mean the ability to have system operators really know what’s happening in real time everywhere on the grid—is really not up to speed.

Ultimately, there are a number of ways in which the “rules” for transmission investment are creating disincentives for making investments in that gadgetry. And that’s the hidden crisis that I’m talking about. We’re depending upon this system more and more to be there for everything we do, and we’re really getting more and more out on the edge of its technological where-with-all—not our technological capabilities, but actually what we’ve got embedded in the grid.

EL&P: How do you see generation developing over the next few years under the shadow of this crisis?

Tierney: There is less integration in planning for transmission in a way that integrates it with generation. There are parts of the country where there have been less unbundling and separation in this arena, and, in those parts of the country, there is still a single entity doing coordinated planning for generation and transmission.

But, there are also a lot of regions where this is not the case. And, increasingly in the U.S., FERC’s rules, which require the transmission organization to do the planning, open up the potential that these regions will fail to connect the dots from the generation side to the transmission side of the fence. And, layer on top of that what we all know in terms of the capital crisis that is affecting generation, and there are serious issues of misalignment of generation with transmission.

So, what does that mean for the outlook? I see some bumps in the road ahead—significant potholes, in fact. I, for one, have been a fan of encouraging competition in the electric generation part of the industry, and I have welcomed the advent of independent system operators in order to enable that generation competition. Yet, I do see that the transmission planning piece of this equation is really something that requires a significant additional amount of work to make sure that we don’t have a crash—a significant, increasingly important disconnect between the two sides. We already see signs of this, where we have had imperfect information passed on to generators about where it is “attractive” for them to locate their investment vis-àƒ -vis the availability of transmission. FERC’s rules for locational pricing go a step in the right direction, in terms of sending the right signal to generators, but, in some sense, those are “late,” because there has been a big wave of generation investment that isn’t necessarily in the right places for serving load in an efficient and reliable way. There is a lot of bottled-up economic generation that has resulted from the merchant wave, and there’s a lot of oversupply.

EL&P: And, obviously, you see this disconnect between generation and T&D being very detrimental.

Tierney: Yes, but I don’t necessarily mean that I encourage us to go back to the “old world.” That’s not the implication I’m trying to draw here. I am suggesting that we need to figure out a new model for transmission planning that not only sends the right pricing signals, but has investment cost recovery rules that are clear—that really get a proper incentive going for adequate investment on both sides. We are not there.

EL&P: Do you see the investment coming, or do you see the T&D side of this industry developing along different lines in the next year or so?

Tierney: I think that in the next year or so we are still in a dance of regulation, and that dance is one in which each partner is trying to move his or her feet in separate directions. And, additionally, a lot of dancers are simply standing around as well. So, everyone is bumping into each other on the floor. And it’s not going to smooth out in the next year or two, in my opinion.

EL&P: How do you see the next year or two developing for companies in the power industry that are attempting to restructure and balance their finances?

Tierney: This is a huge issue, and, for me, the world of electric energy companies falls into two categories. On the one hand, there are those companies with very strong balance sheets. At the moment, those would tend to be companies that are vertically integrated and have a large customer base. Those companies are ones who have a transmission responsibility and a load obligation that is imposed by state and federal regulation. That set of companies is faced with having to make incremental investments to satisfy load, and to do it in a way that enables them to keep their returns. That, in the face of continuing uncertainty about some of these cost recovery rules and uncertainty about future roles and responsibilities with respect to these obligations to serve, means that I don’t know that we’re going to see anything in transmission or distribution investment that isn’t just keeping things in the status quo—as opposed to enhancing technology to satisfy demands of a digital economy.

Then there’s the second group that encompasses merchant generators, some vertically integrated companies without strong balance sheets. And many of those companies face financial constraints (or worse, crises), rate caps, and the like—further exacerbating their financial situation, in some circumstances. And there we’re clearly not going to see this kind of investment.

EL&P: Looking into the next few years then, how important is R&D to the future of the power industry?

Tierney: It’s extraordinarily important. I think we are where we are as an economy that relies on electricity in part due to a historical platform for R&D work in this industry. In the past, it was broadly shared, a lot of collaborative research. One of the downsides of competition is the fact that it drives companies to focus their R&D on the activities that enable them to look for monthly, quarterly, yearly, two-year earnings growth, as opposed to a long-term payout.

Many breakthrough technologies over the years have come from government-funded work—either partially or fully funded—that has been done in cooperation with the industry. But while the basic research work came from government funding, the applications of such technologies moved to the next tier through a lot of collaborative industry research. And, I just don’t think that we’re seeing that these days.

I have been involved with some efforts with regulators, and other industry leaders, through EPRI and other organizations, to try and figure out how to create a framework to do this collaborative research for the future in today’s industry.

EL&P: Are our current R&D efforts headed in the right direction, or is our current R&D focus askew?

Tierney: We’re doing a pretty good job of creating incentives for companies to spend research money on very short-term activities—how to drive their maintenance costs down, for example. That kind of research is good and useful, and it will provide results that align with an investor’s goals—that is, getting to an earnings payoff quickly—and a consumer’s goal of capturing the efficiency benefits of competition.

But, the kind of work that may benefit consumers in the long run—enhancements on the environmental portfolio for example, where we may not see a payoff for five years or so—is suffering. Those are the kinds of technological innovations that we have benefited from in the past.

EL&P: Is there one area of R&D that will “break out” over the next year or so?

Tierney: I’d personally vote for creating a platform for grid enhancement that enables a lot more “smart” operations. The Energy Innovation Institute (E2I) has a consortium of electric companies and government sponsors to invest in the architecture of the grid that will enable, for example, operators in different parts of the country to “see” what’s going on in different regions and neighboring power systems and operate the grid in a more reliable way.

Some of the problems we’ve had in recent years is that operators can see quite clearly what’s going on electrically in their own neighborhoods, but that transparency and clarity stops at their borders. They have serious technical constraints on “seeing” what’s going on inside their neighbor’s system and using that information to operate their system more capably. Their ability to operate their own system more reliably can be enhanced by these kinds of software devices and putting in place common architecture and protocols.

And there’s a growing body of supporters for this research among both industry players and government regulators. And, clearly the federal government is also interested in this program, as it also has a national security element, which is raising the attractiveness of this area at this moment.

EL&P: Is FERC’s Standard Market Design the first push along the right development path for this industry?

Tierney: I have to approach this from two points of view—one with my politics hat on, and one with my economics hat on. With the economics hat on, I think this is a very powerful design, which can send proper signals to consumers and suppliers, if various elements are in place. And, so, in theory, I am a major supporter of it. I’ve watched this kind of market-design platform work in PJM, and, now, it has just come into play in New England. And that’s a good thing.

From a political point of view, there are powerful tensions in the industry surrounding SMD, especially in those parts of the country where there’s less push from the states with respect to competition. Whereas most of the stakeholders, including most of the state regulators, in areas like the Northeast, are relatively supportive of moving forward with SMD, that’s not the case in many other parts of the country—obviously, in parts of the South and the Pacific Northwest, for example. In those regions, to take the position that one wants to introduce SMD come hell or high water, is to invite a series of clashes that will range from legal stalemates to serious confusion and uncertainty over what market and transmission rules will apply to investment and operations in the future. In this scenario, companies are often confused about which direction to move in, as their bread is figuratively buttered by both federal and state regulators. And, they are caught in the middle. So, I think, in that framework, SMD will require a deft political hand to move forward without running into a legal and political battle, which is where we’ve been in for the last year, or year and a half.

EL&P: Are there any specific companies, agencies, geographic regions that, in your opinion, are doing things right—that others should look to as examples to follow?

Tierney: One that comes to mind as an interesting candidate is Public Service Electric & Gas of New Jersey. There we see a company that’s doing pretty well financially. It has structured its subunits in a way that has readied them to play in the regulated and non-regulated parts of the business. They have worked well with other players in the PJM system and are doing very well. In addition, that company has made overtures into other markets in the U.S. and outside the U.S. in terms of their merchant generation and marketing activities. They’ve bellied up to the bar on a number of environmental commitments as well.

In the Midwest, Exelon strikes me as an interesting model. They have run through the traps, after having some tough times—from the point of view of planning for participation in a regional transmission organization in the Midwest, or from a local reliability point of view in recent years, for example. Exelon has gotten down to brass tacks and figured out what the company had to do to turn the local reliability issues around. And, they did it, bringing their system and local distribution reliability up to acceptable standards. They are in fairly healthy financial status, even though parts of their business are still challenging in that respect. They have been on a careful merger and consolidation path and have been weathering that storm. They’ve operated well in two regions of the country and are eager to play a leadership role in the new SMD and RTO world.

Interestingly, I can think of a number of companies that seem to be doing very well: Florida Power & Light seems to be doing very well financially, for example. They have been able to enter into regulatory agreements for their rates, which give them the opportunity to flow back a lot of rate benefits to consumers.

I would put Entergy in a similar category. It seems to be doing pretty well.

EL&P: What’s the most radical concept in the industry that needs to be implemented? (In other words, is there something that industry insiders have a knee-jerk “no” reaction to that actually deserves consideration?)

Tierney: I personally believe that one of the biggest challenges facing our country is the overhang of the climate change problem, and the electric industry—along with the motor vehicle sector—produce the lion’s share of man-made greenhouse gases. We are at a point where our fuel outlook for the electric industry is complicated, not just from an economic point of view, but also in terms of its implications for climate change concerns. There is real tension between market-driven attitudes about certain stable-priced fuels and technologies—i.e., coal, nuclear, renewables, and even energy efficiency—and the fuel of choice in electricity markets at the moment, gas, which isn’t exactly a fuel with stable prices. There’s a push for more gas use on the margin from a technology investment point of view, and there’s a push for more stable fuel prices from an operations point of view. All of these fuels—not to mention oil on the margin—are implicated by the climate change story, although they have quite different implications for emissions of greenhouse gases associated with electricity production and use. And yet the costs of climate change are still not showing up in prices and in economic comparisons of these fuels. And, I think that investment planning, in a market-based way, would be greatly enhanced by more certainty about our policies toward climate change, so that the economics of fuels and technologies can reflect their different greenhouse gas emissions profiles and their implications for climate change. Are we going to have a mandatory cap program? What is the timeframe in which the country will make commitments to reduce its greenhouse gases? Those things are critical to planning decisions made today about fuel choices and generation construction and longevity.

EL&P: Tell us a bit about the Electricity Innovation Institute (E2I) and how you became involved. What do you see E2I contributing to the power industry over the next few years?

Tierney: The E2I Institute is a subsidiary of the Electric Power Research Institute (EPRI). About five years ago a number of advisory council members began to worry about the fact that, as the industry becomes more market-oriented, it is driving EPRI’s members more toward investing in the portion of EPRI’s platform that has a short-term payoff research. Traditional EPRI members became less willing to put their dollars in the portion of the R&D menu that is focused more toward a long-term, public benefit research. By that I mean the kind of research that is environmental, or the long-term grid enhancements, or on energy efficiency or renewables. The bottom line: EPRI members were voting to put their money in R&D items where they could see an earnings benefit and not a long-term social benefit. Totally understandable, of course.

But, this group of EPRI advisors began to scratch their heads and see that this could be a real problem for the industry. We explored a number of different ways to reinvent paths toward funding, and we learned that the government wasn’t willing to give money to EPRI for long-term research in many cases because they felt that EPRI was governed by captains of the electric utility industry, who were the very members who were focusing EPRI toward the short-term R&D programs. So, we needed to create a framework to give people from the public sector confidence that research they might be willing to fund would remain with an eye toward the public interest.

This subsidiary, E2I, is the resulting model. It has its own board of directors, with a great degree of independence from EPRI, while still being able to work with EPRI’s staff and advisors to shape the technical work. With E2I, however, that research strategy is formed through an organization governed by senior people who are independent of the electric industry.

EL&P: Beyond your colleagues at E2I, are there any major industry players that you’d specifically like to have a discussion with, a “fantasy roundtable” of sorts? What would you like to talk to them about?

Tierney: I have a few candidates. On the electric company side, I think there are some really important leaders, whom I admire very much and whom I’d love to talk to: Wayne Leonard from Entergy, Errol Davis from Alliant, Pete Cartwright from Calpine, John Rowe from Exelon, FERC chairman Pat Wood, Leonard Hyman—who is now at R.J. Rudden, used to be from Wall Street—and Sonny Popowsky, the head consumer advocate from Pennsylvania.

I’d pick their brains about this financial crisis we’re in today, whether they see it as a short-lived event or a structural problem that we need to attend to. I would really want to hear how they think we can weather this. Let’s talk about where we are going as an industry and what we need to make this vibrant and keep us world-class without going back to the old model with its problems. Paint me a portrait of the industry five years from now.

Tierney can be contacted at stierney@lexecon.com.

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The Clarion Energy Content Team is made up of editors from various publications, including POWERGRID International, Power Engineering, Renewable Energy World, Hydro Review, Smart Energy International, and Power Engineering International. Contact the content lead for this publication at Jennifer.Runyon@ClarionEvents.com.

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